A Theoretical Analysis of Income Tax Evasion, Optimal Auditing, and Credibility in Developing Countries

Journal of Theoretical Politics, Vol. 22, No. 1, pp. 123-133, 2010

Posted: 6 Feb 2010

See all articles by Amitrajeet A. Batabyal

Amitrajeet A. Batabyal

Rochester Institute of Technology

Hamid Beladi

University of Texas at San Antonio - College of Business - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: February 5, 2010

Abstract

We first construct a theoretical model of tax evasion in a stylized developing country in which all taxpayers have either high or low income. The key problem is that the high income taxpayers may underreport their income. An individual income tax return can only be verified with an audit that costs c. There is a constant tax rate τ on income and a fine F on underpaid tax. In this setting, we analyze two cases. In the first case, the tax authority pre-commits to its audit policy. We determine the optimal audit policy for the tax authority and then we discuss why this policy is not credible. In the second case, there is a fixed proportion of high income taxpayers who report their income truthfully. In this context, we first study the properties of a credible audit policy. Then, we examine the impact of an increase in the three parameters (c, τ, F) on the equilibrium audit policy.

Keywords: Credibility, Fine, Game, Income Tax Evasion, Optimal Auditing

JEL Classification: H29, O12, D82

Suggested Citation

Batabyal, Amitrajeet A. and Beladi, Hamid, A Theoretical Analysis of Income Tax Evasion, Optimal Auditing, and Credibility in Developing Countries (February 5, 2010). Journal of Theoretical Politics, Vol. 22, No. 1, pp. 123-133, 2010, Available at SSRN: https://ssrn.com/abstract=1548457

Amitrajeet A. Batabyal (Contact Author)

Rochester Institute of Technology ( email )

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Hamid Beladi

University of Texas at San Antonio - College of Business - Department of Economics ( email )

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United States
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210-458-7040 (Fax)

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